Equipment leasing is an appealing equipment financing method for many enterprises, but it involves substantial risks if not managed properly.
1. Uninformed decision-making:
In many enterprises, the responsibility for leasing falls on professionals (e.g., purchasing or facilities managers) who lack sufficient awareness of the nuances of lease agreements and the terms and conditions which can appear benign but generate material risk. This lack of leasing and financing expertise can led to situations that inflate risk, such as inadequate analysis of the true “all-in” costs of leasing, failure to identify the best-value vendors, and lax risk control.
2. Additional costs beyond committed rent:
Failing to examine each element of a lease for contract-based financial risk can result in higher than anticipated costs, because potential costs not included in the basic term lease payments are typical in lease agreements.
A common additional cost not taken into account is interim rent, which is charged for the period between the acceptance date of the equipment (when it is placed in service) and the commencement date of the lease’s fixed term.
The way in which interim rent is calculated can have a significant impact on lease costs. For example, there’s an obvious increase in cost if the fixed term begins on the first day of the calendar quarter following acceptance rather than on the first day of the next calendar month.
The lease agreement will also specify how the interim rent will be calculated—it could be at a rate equivalent to daily rent, or it could be a less-costly interest-only charge.
3. Poorly defined end-of-lease options:
A lease’s end-of-lease terms can burden the lessee with unnecessary risks, and lessees that don’t mitigate these risks leave themselves vulnerable to going over-budget and experiencing unnecessary leasing costs.
For example, a typical lease includes an end-of-lease option to purchase at fair market value, but how the fair market value is determined is often left largely to the discretion of the lessor. And even if the lease agreement calls for mutual agreement, lessees can be exposed to additional cost if the valuation process isn’t clearly stipulated, including time frame. Otherwise, negotiations can drag on while the lessee is still paying full rent.
Another example of end-of-lease risk is an all-or-none equipment return provision, which requires that end-of-lease options must be exercised on each piece of equipment in a specific set (as defined by the lease agreement) before the full rent stops for the entire set. This clause makes 100-percent compliance with return policy difficult to achieve, often leading to additional charges.
4. Invalid assumptions:
Enterprises often expose themselves to unexpected risk because they don’t realistically answer questions about the equipment, such as:
- How it will be used?
- How long it will be needed?
- How it will be used?
- How long it will be in use?
- How long it will be technically current?
- How costly it will be to return?
- How costly it will be to maintain and upgrade?
Inaccurate assumptions when answering these types of questions can lead to inacurrate lease vs. buy analyses.
5. Accounting changes:
The accounting standards of the Financial Accounting Standards Board and the International Accounting Standards Board are being coordinated, making a major accounting adjustment possible in 2013. Lease payments will almost certainly be brought "on balance sheet" sometime in the next few years and the impact of that change should be evaluated.
Takeaway Point:
Lease agreements are not low-risk transactions, and they deserve attention by professionals who have the knowledge and experience to minimize risk, develop leasing strategy, identify opportunties for improving lease financial performance, and negotiate terms with lessors that are intricately familiar with how to structure lease agreements to their benefit.
